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Bank Bonds Still Trade at Discount

Gap between spreads on industrial, financial debt has doubled from a year ago.

The biggest U.S. banks will need more than the Federal Reserve’s stamp of approval before they receive an all-clear signal from the bond market.

While relative yields on their bonds narrowed to 265 basis points, the lowest since August, that’s almost 1 percentage point above last year’s low of 173 in April, according to Bank of America Merrill Lynch index data. The gap between spreads on industrial and financial debt has more than doubled from a year ago and credit-default swaps on the six-biggest U.S. banks are 83 basis points higher than last April.

Fixed-income investors are showing they’re not convinced the worst is over from Europe’s sovereign-debt crisis and litigation from faulty mortgages issued during the housing boom, even after the Fed said 15 of the 19 biggest U.S. banks could maintain adequate capital levels in a recession scenario. Bondholders also remain concerned that increased regulations and a slow economic recovery may diminish banks’ profitability.

“It was a positive step, but there’s still risk factors that sit on the table,” Scott MacDonald, head of research at MC Asset Management Holdings LLC, said in a telephone interview from Stamford, Connecticut. “You still have some degree of cautions as to the financial sector vis-à-vis industrials.”

Even as Moody’s Investors Service says financial companies deriving profits from trading and market-making will likely be cut this year, bank bonds have gained 4.7 percent since year-end, on pace for the best quarter since the three months ended September 2010, Bank of America Merrill Lynch index data show. That compares with industrial debt returns of 0.6 percent. In 2011, a 1.7 percent gain for financial securities’ fell short of 9.9 percent on industrials.

“All these dominoes fell between March of last year and March of this year,” said Jody Lurie, a corporate credit analyst at Janney Montgomery Scott LLC, citing the earthquake in Japan, debate over the U.S. debt ceiling and Greece’s worsening debt crisis. “During that time period, banks took center stage in terms of investors’ anxieties.”

Elsewhere in credit markets, the cost of protecting corporate bonds from default in the U.S. declined for a seventh day, with the Markit CDX North America Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, dropping 0.9 basis point to a mid-price of 90 basis points as of 11 a.m. in New York, according to Markit Group Ltd. That’s the lowest level on an intra-day basis since July 5.

Bondholder Protection

The index typically falls as investor confidence improves and rises as it deteriorates. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of debt market stress, rose 1.04 basis points to 26.25 basis points as of 11:05 a.m. in New York. The gauge, which has climbed from a six-month low of 24.69 on March 2, widens when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate bonds.

Bonds of American International Group Inc. are the most actively traded U.S. corporate securities by dealers today, with 89 trades of $1 million or more as of 11:08 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

The Fed’s Comprehensive Capital Analysis and Review tested banks to ensure they have adequate capital to continue lending in a downturn and avoid a repeat of the crisis that resulted in a $245 billion taxpayer bailout through the Troubled Asset Relief Program.

The stress tests showed that a U.S. unemployment rate of as high as 13 percent, a 50 percent drop in stock prices and a decline in house prices of more than 20 percent would produce aggregate losses of $534 billion over nine quarters.

“While on one hand, yes, we’ve made tons of progress from the wides, there’s still a ways to go,” Janney Montgomery Scott’s Lurie said in a telephone interview.

The ongoing review by Moody’s may result in one- to three-step credit downgrades at banks including Goldman Sachs Group Inc. and Morgan Stanley is also weighing on lenders, according to analysts at JPMorgan Chase & Co. and Barclays Capital.

Banks that profit from trading and market-making, as well as European lenders, will likely be cut this year, Moody’s said Feb. 15. The ratings company cited regulatory burdens as a challenge, as the U.S. plans to implement a ban on proprietary trading in five months called the Volcker rule, part of the Dodd-Frank financial regulation overhaul.

Mortgage Litigation

The Fed tests were “a bigger story for equity” as “the credit market remains more focused on the Moody’s actions,” JPMorgan analysts Kabir Caprihan and Matthew Hughart wrote in a March 14 note.

Shobhit Gupta, a credit strategist at Barclays Capital in New York said in a telephone interview that potential rating actions and mortgage litigation “are likely to be important catalysts for bank spreads in the near term.”

Last month, Bank of America, JPMorgan, Wells Fargo & Co., Citigroup Inc. and Ally Financial Inc. agreed to a $25 billion settlement with 49 states and the federal government to resolve claims of abusive foreclosure practice.

The gap between spreads on bank bonds and industrial debt has narrowed to 102 basis points, the tightest since reaching 99 basis points on Aug. 8, Bank of America Merrill Lynch index data show. That compares with 44 basis points reached last April. Financial spreads last traded tighter than industrials in September 2007.

“It’s unlikely we’re going to get there any time soon, but the basis could definitely compress if we continue to get stability in the market,” Gupta said.

While European efforts to resolve the debt crisis are making progress, “imbalances” in euro-area economies show that the task is far from complete, German Chancellor Angela Merkel said on March 13.

“Even though we are through a large percentage of the near-term crisis with Greece, there still are other layers of this crisis that may develop,” said Thomas Chow, a money manager at Delaware Investments, which oversees about $170 billion of investment-grade debt. “The economy over there, given the austerity measures in place, are certainly going to be a drag and put pressure on the financial system,” Chow said.

An index averaging five-year credit-default swap prices on debt from U.S. banks Citigroup, JPMorgan, Goldman Sachs, Morgan Stanley, Wells Fargo and Bank of America has declined to 187.4 basis points from last year’s high of 360.1 on Nov. 25, the highest since April 2009, CMA data show. The average is up from this year’s low of 181.8 reached on Feb. 8 and 104.6 on April 11, the lowest level of 2011.

“From a credit perspective, we know the banks theoretically can weather a pretty dire type of scenario,” said Adam Steer, an analyst at Brookfield Investment Management Inc., whose parent Brookfield Asset Management Inc. oversees about $150 billion in assets. “They got the all clear from the Fed but there’s still uncertainty in the near term.”

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